Are we aligning pay to the wrong performance metrics?

As discussed in this article in Compliance Week, this report, “The Alignment Gap Between Creating Value, Performance Measurement, and Long-Term Incentive Design,” by Organizational Capital Partners and the Investor Responsibility Research Center Institute, contends that most companies are using the wrong metrics to align executive pay with performance. Rather than using metrics related to creating sustainable, long-term value, the report maintains, companies are tying compensation to short-term market returns – a practice the article characterizes as the “tyranny of TSR.” What’s more, the article concludes, “[d]ivorcing pay from performance has real-world consequences—troubling ones. Nearly half the companies in the S&P 1500, some 47 percent, actually destroyed value by earning a ROIC [return on invested capital] less than their cost of capital over the five year period ended 2012.”

The report, which studied companies in the S&P 1500, asserts that the “best measure of economic value creation is economic profit, i.e. net operating profit minus a capital charge for invested capital. Economic profit, unlike conventional profit, subtracts input cost from output value to get true value creation.” But economic performance seemed not to account for variances in CEO pay (only 12%), while factors such as company size (44%) and compensation history (19%) were more relevant. Moreover, “[m]eaningful economic value creation is ideally measured over the longer term.” The report defined “long term” to mean a period of at least five years. But almost all “long-term” incentives had performance periods of three years or less. The report also indicates that constant changes in performance metrics served to reinforce short-term thinking.

In sum, the report concluded that “most common measurement tools and metrics used in enterprise performance measurement and the design of long-term incentives do not necessarily directly align with underlying sustainable value creation for shareholders.

Some 75% of companies have no balance sheet or capital efficiency metrics in their long-term incentive plan design,

Total shareholder return is, by far, the most dominant performance metric in long-term incentive plans, present in over 50% all plans,

Only about 17% of companies specifically disclose the use of return on invested capital or economic profit as a long-term performance measure for long-term executive compensation,

More than 85% of the S&P 1500 have no disclosed ‘line of sight’ process metrics aligned to future value, such as innovation, and related drivers.

On the positive side, the use of performance-based incentive vehicles in long-term incentive plan design has increased every year since 2009 – from 52% in 2009 to 76% in 2013.”

The report finds the first two bullets to be particularly problematic. The article explains that, to create value, ROIC must ultimately exceed the weighted average cost of capital. However, the absence of balance sheet or capital efficiency metrics in long-term incentive plans means that “boards can have no idea whether value is being created or destroyed when they approve bonus payouts.”

Moreover, tying compensation to share price appreciation through total shareholder return (TSR) is deeply misguided because factors that affect share price, such as “fund flows, central bank policies, macroeconomics, geo-political risks and regulatory changes are all beyond the control of executive management.” Even “relative TSR, as conventionally calculated, also assumes re-investment of all dividends, and hence, does not properly capture those situations where value is created by decreasing the level of capital invested in the business.” (Note, however that the report does use relative TSR for some measures.) The article attributes the imprudent focus by companies on TSR to the influence of “boards, institutional investors, and proxy advisory firms [that] have insisted that executive compensation center around ‘alignment’ of CEO and named officer compensation with short-term market returns, rather than on creation of economic value over time….Compounding the problem is that executives can’t manage to TSR; their decisions can have only so much [effect] on stock price….Advocates for TSR note that it is observable, objective, and measurable. That is all true. But it is also irrelevant; lots of measures boast those attributes. If you lined up CEOs and measured their times in a 40-yard dash, those results also would be observable, objective, and measurable, too. And they would have about as much to do with real value creation as TSR does.”

Growth in earnings and EPS were the most common operational metrics; however, the report argues that these metrics “do not take into account the level of invested capital, cost of capital or future value built into enterprise valuation. So, for example, a company could boost higher earnings and higher earnings per share following a value-destroying acquisition, if that acquisition were paid for with debt that did not come due during the measurement period.” The types of factors that typically drive long-term value creation — innovation, new products, customer loyalty, environment and employee engagement – were included as operational metrics for less than 15% of long-term plans. One result of that way of thinking, the article suggests, is that “major inputs into the creation of future value such as research and development investment and net new capital expenditures have declined from 2.9 percent of revenue in 1998 to 1.7 percent in 2012. That is a 41 percent decline on a revenue-adjusted basis. Senior managers are by and large not rewarded for those kinds of investments.”

What should boards do? The report suggests that companies could better align executive pay with long-term shareholder value by the following:

Applying value-based performance metrics such as ROIC greater than the cost of that capital and economic profit instead of the current heavy reliance on TSR or EPS;

Including metrics that drive future value, such as innovation;

Extending the performance period beyond three years, and preferably to “a five-year rolling performance cycle”;

Stabilizing the performance metrics and peer groups to the extent possible over multiple performance cycles to de-emphasize short-term thinking; and

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